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Following my earlier writing on the Digital Wallet / ePayments and how such transactions may have not breached Shariah requirements but lacks the validation to ensure all elements do not touch the prohibited elements, I am called to further expand on the topic. In my opinion, there are possibilities that more Shariah-Neutral products and transaction enter into the space of Islamic Banking, but without the validation of Shariah scholars or committees and yet, it will remain acceptable. It is possible, and it is already happening now.

“NO PORK NO LARD”

It is an interesting situation in Malaysia now, when it comes to food. In general, Malaysia as a Muslim country, the expectation is that the food consumed must be Halal and more importantly certified as such. The reason for it is that it gives comfort to the public that certain standards are adhered to according to religious requirements. To walk into a restaurant with the Halal signage gives us Muslims confidence to consume the food till our bellies are filled.

But there are challenges. The desire to ensure the standards are met has resulted in difficulties for restaurants getting certification quickly. The process is detailed and granular, and this is a good thing, but can be disheartening when the certification drags. And in some cases it is impossible to obtain, especially if the eatery has halal standard food but also offers alcoholic drinks to its non-Muslim customers. The Muslims know (or assume) the food is halal if they see there is no pork on the menu, and will ignore the alcoholic drink. This is now a common sight in Malaysia.

And thus the loop-hole or short-cut is discovered. Rather than going for certification of Halal for their restaurant, many owners now deemed it sufficient that the signage “No Pork / No Lard” will result in a Halal understanding. And this may be true; many small roadside businesses do not carry a Halal certification but is nonetheless patronised by Muslims as it does not carry pork on the menu. That cue is taken by the restaurant owners and over a period of time, the “No Pork / No Lard” now is understood to be serving halal food but without Halal certification.

DOES “NO PORK / NO LARD” MEANS IT’S SHARIAH NEUTRAL?

Taking that concept into the banking world, will consumers eventually be accepting Shariah Neutral products and services as the new norm? A product or services with no prohibitive elements that is deemed acceptable by both the producer and consumers but without any Shariah Committee validation. For many years some conventional banks have been offering Shariah compliant third party Takaful or Unit Trust products which was vetted by the Shariah Committee of the providers.There is total reliance on the providers validation for Shariah compliance.

Additionally, there are products and services that is by nature, very close to meeting the Shariah requirements in a contract. For example the leasing products which is perhaps 95% in line with Shariah requirements for Ijarah such as rental arrangements, ownership transfers and roles and responsibilities of lessor / lessee. The contention will always be the penalties and perhaps some operational practices, but in my view, these can be amended.

THEY WALK AMONG US

Believe it or not, there are already efforts on becoming Shariah-neutral where it is deemed acceptable practice for attracting Muslim consumers. Some non-Islamic banks have been aligning some of their products features to be consistent with Islamic banking practices under the guise of responsible financing or sustainable banking. For example, the compounding late payment interest which some non-Islamic banks no longer practice. Another example is that some are considering to remove “Commitment Fees” from unutilised financing balances in overdraft / revolving credit to align it to Islamic banking practices. We are starting to see non-Islamic banks realigning themselves to be on par with Islamic banking practices. Just to regain the competitive edge.

This will eventually lead to offerings that remove the prohibited elements and validated as acceptable by the public themselves, without further validation of Shariah scholars. Can a non-Islamic bank eventually offer products that it deemed as meeting the Shariah expectations? Surely, Shariah Committee will not have jurisdiction over a non-Islamic bank offering Shariah-Neutral offerings.

The more crucial question is perhaps : Will the public eventually become not so demanding for a stricter (or complicated) Shariah Compliant product, and begin accepting Shariah-Neutral products that is offered by non-Islamic banks? Is that possible?

Such offerings may be offered via the digital world where the contractual lines are not so clear. Rebranding of a product can be done with minimal effort. The terms used can be made Shariah-friendly. How a transaction is handled behind the scenes may be less important with the convenience of using Apps or Mobile Banking. And without Shariah scholars prohibition or decision on such matters, the public will hold to the opinion that it is deemed compliant and thus acceptable. Eventually, this opinion will become customary and generally accepted.

“No Pork No Lard” may one day become the new acceptable norm in the non-Islamic banking space. And my suspicion, a lot of sceptics of Islamic Banking already hold this view. Maybe it is time to make clear of the colours of the offering; is it white or is it black? Otherwise, the colour of grey will become the new white.

In the course of our job, we are often asked what are the value proposition and selling points of taking an Islamic Financing product as compared to a conventional loan. Are there certain conditions to qualify a person for taking Islamic Home Financing? There are misconceptions that Islamic financing are expensive, but if that is true, why would there be a growth in Islamic financing? Would people have to be extremely religious to accept an expensive / inferior product no matter what just because it is Shariah compliant?

There are certain features in-built in an Islamic structure that gives benefits that appeal to certain types of customers, based on their needs and requirements for the product. On the flip side there are also consumers that prefer other features not possible for an Islamic structure. It depends on your requirements when it comes to your usage.

BENEFITS OF ISLAMIC HOME FINANCING

No Lock-in Period or Early Settlement Penalty for financing. In the banking world, there is a lot of effort to on-board a customer for a particular financing, and home financing is one of them. The process can take 3-9 months and involves a lot of people and it is natural for a bank to want to earn income as much as possible, as long as possible from the customer. That would not happen if the customer settles early. The bank will impose a minimum “lock-in” period of between 3-5 years where customers are prohibited to sell, settle or refinance their houses. If they do, an early settlement penalty (usually 1.0% on the amount to be settled) will be imposed. Under Islamic financing, this feature is not generally accepted due to the concept that “Debt Cannot be Forgiven, even in Death”. Therefore to impose a penalty when a customer is attempting to pay off its debt remains an issue in the area of Islamic Banking. This is outline in the Ibra (Rebate) Guidelines issued in 2011 which prohibits such charge (Item 8.3). But that is not to say any penalties cannot be charged for the product. Such allowances are given if the product is sold based on a promotional rate, for example 2.0% p.a. lower than the normal financing rate for special campaigns or conditions. In such cases, the bank can recover the “discount” if the financing is settled within the lock in period. Actual cost or loss incurred by bank can be recovered (to avoid abuse). Another example is when a bank absorbs the legal fees for the financing, that actual expense can be recovered if early settlement is made within the lock in period. This Shariah requirement have proven popular for customers seeking short-term financing (plans to upgrade their properties within a few years) as well as property investors seeking for options to dispose properties when opportunities arises.

100% Stamp Duty waiver for Home refinancing. This feature is available in Malaysia where the government agrees to allow for a 100% stamp duty waiver for Islamic Financing when it is refinanced from a conventional bank. This is to encourage the refinancing market as it appeals to customers seeking additional financing on a property’s capital gains. For example, 10 years ago the customer took up a loan for RM500,000 on a RM600,000 property which is now worth RM1,000,000. As the balance outstanding on the loan now is RM300,000, the customer is seeking another RM400,000 cash to finance a renovation. If the customer intends to move the loan, the customer will incur a stamp duty for RM700,000 (i.e. RM300,000 existing + RM400,000 additional). However, moving it to an Islamic bank, the existing stamp duty for RM300,000 will be totally waived and only the additional (top-up) amount of RM400,000 will incur the normal stamp duty. This waiver is applicable for all refinancing from conventional bank to Islamic banks on the amount refinanced (provided the original loan has already paid for the stamp duty prior to the refinancing). This applies for individual customers as well as companies.

Ceiling Rate Price Protection. While many years ago, this feature is mis-sold by many sales person as being oppressive and expensive, with the current climate of changes, this have instead become a competitive benefit for Islamic Banks. The key changes that happened in the past few years was first the Ibra’ (Rebate) guidelines issued by BNM in 2011 and also the Reference Rate Framework in 2014 (Item 8.10). The Ibra’s guidelines says it is ok for the bank to charge a ceiling rate to formalise the Aqad, but the day-to-day charging of the customer must be based on a mandatory rebate mechanism where the effective rate is at par which what a conventional normal benchmark rate is. This means that the customer is not overcharged. More importantly, the customer will not be charged more than the ceiling rate should the normal benchmark rate increase to above the ceiling rate. This provides the customer price protection against high fluctuations of the benchmark rates. Some might say that there is no way rates will breach the ceiling rate but if you look at the length of a financing product of up to 30 years, who is to say the benchmark rates won’t breach during an adverse economic cycle? More importantly, the Reference Rate Framework allows for punitive pricing where banks are allowed to increase the loan/financing rates based on customer’s risk profile to up to Effective Rates +3.50% p.a. If a commercial financing of BFR + 3.50% is about 10.30% p.a., that is not too far away from a normal ceiling rate ranging from 12% to 15% p.a. So, with a Ceiling Rate you get the best of both worlds; if the benchmark rate is below the ceiling rate, you enjoy the benchmark rate (same as conventional loans), and if the benchmark is above the ceiling rate, you only pay based on the ceiling rate (not the same as conventional loans).

GIVING BETTER SOLUTIONS THAT SATISFY SHARIAH REQUIREMENTS

The top 3 reasons above are some of the main drivers for Islamic Financing. For item 1it is the BNM effort to provide Islamic Banks with a competitive edge based on Shariah instructions. For item 2, it is the government of Malaysia initiative to provide stamp duty incentive for a specific segment ie refinancing segment. For item 3, it is the Shariah requirement to have a ceiling rate which protects the consumer from uncertainty. All these 3 elements come together to provide a competitive advantage to banks and benefit to consumers.

There are a few smaller advantages to an Islamic financing structure (based on specific products such as No Commitment Fees for Islamic Revolving Credit or Overdraft), but it is too many to list down. Granted, these features are incentives and assistance by relevant parties to make the products attractive, and may not be applicable for products outside Malaysia.

In conclusion, the above demonstrates the ability to take a Shariah requirement to make it into a benefit for consumers. This aligns with the idea that Islamic Banking products must contribute to the sustainable practices that offers fair an equitable solution to consumers.

Apps are everywhere. Everyone has a mobile phone where people start to get used to online banking, e-money, e-wallets and e-payment. All at the touch of the screen. I use it extensively and there are a few very convenient ways to survive a city without the need of actual cash in your wallet. Everything is digital and floating somewhere out in the clouds.

As I no longer use credit cards, I relied heavily on Debit Cards as my main payment medium which is linked to my Islamic Current and Savings Account. So the Debit Card deducts the amount from my account for each purchase for settlement. Technically, it is a Service (Ujr) where the Debit Card serves as a payment instrument, linked to the account based on Wadiah or Qard or Tawarruq or Mudarabah.

But at the same time, I am all-in into the tech-thingy as well. And no doubt, there must be a future in these thingies… For the past few months, I have been using these few apps. Here is a short review of 2 apps that I have to admit as my favourites.

Boost was one of the first eWallet that I downloaded. It requires me to “fund” the wallet, and when you make payment using the money in the eWallet, you can shake your phone to get “digital rewards”. So far, I have only gotten maximum RM2 for my phone shaking, with the promise of random potential rewards. I am motivated to shake, maybe I can win the grand prize (it changes from period to period). What is the Shariah contract here? Boost eWallet is funded from my Islamic bank account, so what is the contract for the eWallet? Is it a Qard (loan), or Wadiah (safekeeping)? We potentially may get a return (profit?) after a purchase by shaking our phone. Is that considered discretionary returns i.e. Hibah? Promised returns? In a way it is a promised returns but the amount is based on luck. And what does Boost do with our money when we are not using it and is it used for Shariah compliant purposes? Is it potentially a Musyarakah (partnership) or Mudarabah (profit-sharing) arrangement as customers are the Rab Ul Mal (Fund Provider) and Boost is the Mudarib (Manager) or Shirkah (Partnership). The Capital is guaranteed so it is maybe a deposit arrangement. The fact that we can transfer it back to our account sound like it is a Qard arrangement where we can ask our cash back on demand. But getting to shake for a guaranteed reward (even though it is RM0.20) may pose Qard as problematic for offering rewards.

Fave is another app that I use, which is slightly different from Boost. Where Boost is an eWallet, Fave is a Payment Gateway where the cash is taken directly from your Bank account to settle a purchase. And depending on the merchant, you get cash back on your purchases which could be deducted from the your next purchase amount, ranging from 5% to 10% (some don’t offer cashback, but rarely). In Fave’s case, Fave do not retain any cash from you, as your cash still remain in your Bank account. So Fave seems to be more of an Ujrah arrangement, where we presume the service fee is collected from merchants instead of you. To encourage you to use this App so that Fave collects their fees, Fave gives the cash-back based on % of your purchases which seems like Hibah (gift) to me. For example, I pay for RM100 and gets a “cash-back” of RM5 for my next purchase at the merchant, so that sounds like a gift. Or is it a commission that we get for using the App, redeemable for the next purchase? I don’t know.

THE SHARIAH IMPLICATION

When we use these Apps, it is not clear the modus operandi of the operator and it seems obvious that no Shariah consideration took place on the usage as well as the contractual relationship. Should there even be any consideration or is it necessary?

In my view, a lot of products and services in the market fall into the category of “Shariah Neutral” instead of Shariah Compliant / Non-Shariah Compliant. For example a transaction may look like an Ijarah where the payment is based on rental but its documents may not be completed or contain all the tenets of the contract. Without the elements of all the shariah tenets, will it fall into either Shariah-neutral or non-compliant?

The question : If the transaction is Shariah Neutral, is there any requirement to look at by Shariah scholars? How do we decide if it is Shariah Neutral and therefore should be ignored from Shariah oversight?

Have Shariah Scholars considered the digital world or are we still only concerned on the traditional products to see their process validity and documentation? I feel there is a growing gap of what we see developing in the fintech, mobile banking and digital commerce space where Shariah may or may not have an issue on.

For example, the issue of Aqad in the digital space. The questions that I have are the following:

Are the minimum tenets the same between a transaction between people, and a digital transaction? For example the tenets of a Murabahah in the digital space. Buyer / Seller / Price / Asset / Offer Acceptance. Will the tenets in the physical world still apply in a digital world?

I presume the Buyer is the customer. But the Seller is a program that shows a picture of a product and is automated. Will the Seller as an Apps (representing the Seller) qualify as a real seller under the tenet? Generally I would think so but the responsibilities of the Seller must be clear somewhere.

Would an Apps Pop-Up notice sufficient to conclude an Aqad. These are sequential programming that gives notice/remark at certain points and can be timed to meet Shariah requirements. Is this sufficient for Shariah?

Maybe I have been too distracted by work that I have missed these discussions, if it has happened before and concluded.

SHARIAH NEUTRAL : IS THERE A NEED TO VALIDATE?

As far as I understand it, Shariah Neutral means a product or services that is not breaching any Shariah rules or prohibited items in its execution. For example, a remittance service, where the customer gives cash to a remittance company to transfer the amount to another party. The company provides a service and earns a commission for the service. There are no prohibited elements in such service even to the point that generally the tenets of the contract are deemed as embedded in the processes, intention and basic forms and documents. You don’t see the arabic terms or formal contractual relationships mentioned; by virtue that there are no prohibited elements, we deemed it Shariah sufficient.

WHAT IS SHARIAH’S REAL VIEW OF SHARIAH-NEUTRAL?

I may be ignorant in this area, but what is Shariah’s view on Shariah-Neutral transactions? Why is it deemed that certain transactions requires a written / documented contract with all relationships and responsibilities outlined and agreed upon for it to be Shariah-Compliant, while others are okay to remain in a Shariah-Neutral state and still be acceptable? What is the deciding criteria for qualification of Shariah-Compliant?

As we move into the digital world where buying and selling online become a norm, and payment of goods and services are effected via a mobile app, is there a need to see whether there is any presence of prohibited elements in the transactions? Is there a need to decide if there are elements of a Riba (usury), Ghrarar (uncertainty) or Maisir (gambling) in the transactions? How about justice, fairness and trickery in the documents or operations of a mobile commerce? Is it safe to assume at least Shariah-Neutral and therefore Shariah scholars can skip looking into it?

Can I now design a product that on the outset can look and feel consistent with a Shariah-Neutral approach? With more and more Apps for commercial transaction being introduced, should I start to think about avoiding the prohibitive elements, without the need of complicated documentation and Aqad? As long as it avoids the prohibited elements, I guess it can survive unquestioned.

Does Shariah have a view on Shariah-Neutral transactions? How far do they see to decide if a transaction is Shariah-Neutral and therefore “outside” their jurisdiction.

SUMMARY

As we look forward to living into a progressively digital world, I cannot help but wonder on the necessity to have Shariah oversight online. The Apps developer won’t be going to Shariah scholars to get Shariah endorsements anytime soon, but are they aware of what they developed contains any prohibitive elements from Shariah? Often we are left out of such discussions; perhaps we ourselves feels such development falls into Shariah-Neutral and therefore requires no oversight. But then how do we decide how it falls into Shariah-Neutral territory? Are there checklists we can refer to?

These are the things that comes to my mind while I wait in line to purchase my next drink. And wondering how much I will get from shaking my phone for the rewards. I am hoping for something more than RM5 this time. Happy shaking your phone. What a different world we are living in now. Wallahualam.

It remains a mystery when people ask me why Malaysia continues to offerBai Bithaman Ajil (BBA) and Bai Al Inah products, as according to them, these structures are based on elements of Hilah (trickery). It is a mystery because starting from 2012/2013 period, the instructions on Interconditionality issued by BNM to Islamic Financial Institutions requires that the provisions of “mandatory buy-back” must not appear in financing contracts such as Bai Inah and BBA. Because of this, Malaysian Islamic Banks have slowly weaned itself from such products and have since moved to other Islamic contracts.

In general, I still find that some learning institutions are incorrectly teaching students that the contracts are still alive and well in the Malaysian market. The text books used are still ones that predates 2011 and really, this is a disservice to students. When they come for interviews with our bank, it does not give the students any advantage or good impression as the syllabus remains outdated. Many do not know about the Policy Documents issued by Bank Negara Malaysia or the contracts covered by the policy documents. This really should be covered in a learning module as the latest requirements are captured in these documents. It is a good reference read, but it seems only practitioners and Shariah scholars are aware of these documents.

This is true as my last few interns also impressed the same. Tawarruq structures sounds alien to some of them, as their teachers prefer to teach BBA and Bai Inah to unlock its controversies as points for discussion. Let us be clear that most banks NO LONGER offer Bai Inah or BBA, and those which does, offer it as a continuation for a legacy arrangement or due to certain unavailable scenarios, such as fresh new documentations are not obtained for Tawarruq arrangement (such as Wakalah to buy commodities). It is no longer offered as a product to the public and this is evidenced from the Banks website where the structures can no longer be found. And most of the time if used, this is a temporary fix allowed until the deal reaches expiry or the Tawarruq appointments are obtained.

And with Tawarruq arrangements now being ably supported by good infrastructure such as Bursa Suq As Sila trading platform and other commodity brokers worldwide, there is no issue of Darurah (emergency) to justify the continued usage of Bai Al Inah or BBA.

SO, WHERE HAVE WE GONE TO SINCE 2011?

In short, we have moved to the following contracts:

Bai Bithaman Ajil (BBA)– Usually BBA is used for purchasing of properties (Home financing or Commercial properties financing), or sometimes for trade financing products. These usage is now done under the Tawarruq arrangement (using Commodity Murabahah) where the proceeds from the sale of Commodities is used to settle the purchases of houses or commercial properties. Alternatively, MusyarakahMutanaqisah arrangement (Diminishing Partnership) is also used by many banks where houses or properties are purchased by the Bank and leased out to the customer, who then pays rental and gradually purchases the shares of the house and properties over time. So now, BBA has been replaced with Islamic arrangements of Tawarruq or Musyarakah Mutanaqisah. Other Islamic contracts has also been known to support some elements of BBA, such as Istisna’a (property construction), Murabahah (good sale at profit) or Ijarah / Ijarah Mausufah fi Dhimmah (forward lease).

Bai Al Inah – Usually Bai Inah is deployed for Personal Financing or Working Capital Financing and even Islamic Credit Cards. Again, Tawarruq arrangements has generally replaced these usage with the end result of providing cash. On a smaller note, the contract of Ujrah (Services) is also deployed to support some requirements of personal financing (where purchase of goods and services are required) and Islamic Credit Cards. So now, Bai Al Inah has now been replaced by Tawarruq arrangements or Ujrah contract to meet the cash and working capital requirements.

The final controversial contract that Malaysia currently deploy is the Bay Ad Dayn (Discounted Sale of Debt), which serves a specific purpose in trade financing products. Eventually a common ground must be found to make this contract more globally accepted, or replaced with a better solution.

UPDATE YOUR STUDY NOTES, PLEASE

The main challenge nowadays is to innovate further by improving what we have. Criticisms are good, especially on the old structures. But we practitioners do hope the learning academia afford us a bit more confidence and trust, especially these criticisms and consequent issues are not “unknown” to us, since we lived and breathed in its controversies many years ago. The comments made in recent times are something we had encountered and resolved 10 years ago. We enhance and evolve, and it will be good to see new students coming into the market armed with the latest updates of what is happening and let’s move forward.

It is now 2019. Do not get stuck in the muddy past. These contracts have gone into the history books. We have so much to do in the future arena.

I came across an interesting article titled Hidden Traps in Shariah Decision Making by bro Ehsanullah Agha (click on picture for full pdf article). The article summarises what we product developers have known for quite some time now, and has now become necessary tools in ensuring the products we design are approved by our Shariah Committee. It summarises the involvement of Shariah in decision-making in an IFI, as well as some of the “traps” that Shariah Committee falls into when making decisions.

The 4 “traps” mentioned are:

Anchoring an opinion

Adhering to the Status Quo

Confirming Evidence to support a decision

Framing of information

While the above is referred to as “traps”, I would rather refer these as “approaches” to solicit a decision, and perhaps all the above can come together (not exclusively) in considering a decision. Reading the above exclusively may give the impression that a product team can resort to a specific tactic in order to extract a certain decision. Admittedly, there are such cases, especially where management requires a specific decision to support a business. But Shariah Committees are often expected to be the gatekeepers for such decisioning.

A quick comment on the above points:

Anchoring. While product teams do not consciously try to anchor an opinion before presenting to Shariah Committee, we often do so to provide perspective on the rationale for such proposal. This can be done by highlighting a crisis or regulatory danger to support the proposal. It becomes the baseline discussion point during the deliberation stage. And we do it to keep the discussion in focus to achieve the objective ie resolving the crisis.

Status Quo. By far this is one of the main consideration of an approval by Shariah Committees. Usually we call it Urf ie customs or acceptable market practice on a certain product behaviour. Personally, decisions based on Urf is not something I prefer but it is sometimes necessary to quote as such, especially if there is no major criticism on its usage and practice by the public (which also includes religious scholars). There is nothing wrong with accepting the norms of the society; my only contention is that I may not fully understand the deliberation points when such decisions are made by other parties for the fear of missing out a critical argument that should have been known and resolved by my team. Two things come to mind; Ignorance is bliss, and Blind leading the blind.

Confirming Evidence. This is also a key point where a certain decision is preferred over the other. When there is a bias for arriving at a certain decision, the product research, analysis and design (including practicality in operations) are equally biased in finding evidence to support reaching of that decision. Rightly so as mentioned in the article, the evidence to support the contract of Bai Inah in Malaysia is generally extracted from the Shafie school of thought while sidelining the rest of the opinion that is equally valid. The evidence provided for the acceptability is biased to enable the consideration to approve the structure.

Framing. In my opinion, framing is a necessary tool for product development teams simply due to the amount of information available in the market. While we understand the need for a robust deliberation session with the Shariah Committee, the forums available to us (and the allocated time given) are usually restrictive. To go into full academic and technical discourse will be challenging especially when a quick decision is required. The information that we provide are those we deemed most relevant to support the proposed solution. There may be other decisions that the Shariah Committee can arrive at, if only we had provided more information. But the danger lies where the inclusion of too much information may result in indecisiveness or confusion. Sometimes too much information clouds the real issue further, and it takes time to bring things back into focus. Therefore, we frame the information relevant to the issues. The intention is not to exclude, but to include what is relevant.

A GOOD DECISION COMES WHEN ALL PARTIES ARE ENGAGED

When a product team goes into a proposal, discussion or request for a certain decision, the Shariah Committee is expected to be conversant with the topic at hand to be able to engage in a meaningful discussion. The product team brings in the technical requirements, with some general Shariah background information, market analytics and practical implication on process requirements expected by Shariah. The Shariah Committee must bring in their expertise in Shariah knowledge to dissect and analyse the team’s proposal, not just what is being presented as information but also the rationale, the intention and the technical nuances proposed for the product.

Asking the right question is important for the Shariah Committee, just as providing the right context and intention is also important for the product team. In general, the product team must not go into a Shariah proposition with the intention to manipulate, coerce or blindside the Shariah Committee into a “business” decision. The effort must show full consideration in compliance with Shariah. As much as the heavy burden placed on the Shariah Committee shoulders are real (with fines and jail-time outlined under IFSA2013 when there’s failure to execute their duties), the same burden must also be felt by the IFI’s product team whenever a product is being designed and launched. The people I work with, I see strong commitment and awareness on the need to do the right things, all the time.

WISH LIST FOR 2019

It is easy to expect Shariah Committee to be well versed in all aspects of banking and finance when the decision is required. And it is also easy to expect product development teams to be fully aware of all “relevant” information to be able to share them objectively with the Shariah Committee. Such an ideal scenario will mean all parties come to the table fully aware of all the potential issues, with sufficiently extensive information and in-depth theoretical research to support all the argument. This does not always happen in real life.

I believe the only way to bridge this expectation is to significantly increase the knowledge of all parties. We see this starting to happen at the Shariah Committee level where BNM now encourage at least 1 industry expert to sit in the Shariah Committee, even without a Shariah background. This is to promote knowledge sharing and a different point of view during decisioning, and take notice of any attempts to coerce a decision.

On this same vein, I believe the next natural step is to have Shariah-trained individuals to become product developers in IFI. Most Shariah-based graduates that we see, enter into the banking world via the Shariah department. But how about entering other departments such as sales, credit or more importantly product-development? Such background knowledge in Shariah may itself force a self-regulating approach when designing a products. The Shariah arguments will be the first filter when assessing a product; if it fails at that filter, it will not see the light of day. And Shariah Committee can take some comfort that the Shariah deliberation has already started at the onset of the product development process.

I have seen some impressively good work done by Shariah-based product developers. This should be the way forward in finding new Shariah-compliant banking solutions. Hope I get this wish next year. Looking forward to 2019.

UNDER ISLAMIC FINANCE, YOU HAVE TO PAY FULL SELLING PRICE NO MATTER WHAT.

One of the misconceptions that plague the Islamic Banking financing in Malaysia is that once the Customer agrees on a price in an Aqad (Offer and Acceptance of Sale & its Terms), there is no backing out of the Selling Price and other considerations. If a house at current Value of RM400,000 (Principal) is purchased from a Bank at a Selling Price of RM1,000,000 to be paid in instalments over 35 years. This means the profit earned by the Bank over 35 years is RM600,000. The misconception is that when the Customer intend to Sell-Off or Pay-Off the financing in let’s say Year 8 of 35, the whole amount of RM1,000,000 must be paid to the Bank due to the concluded Aqad, where RM1,000,000 is contracted. So, if at year 8 the Customer has paid a total instalment of RM110,000, the remaining RM890,000 is still payable by the Customer. Whereby the Principal Outstanding for the Financing is RM320,000 in this scenario.

For a Conventional Loan, the amount payable is the Principal Outstanding of RM320,000 + any interest outstanding (earned but not yet paid) + any early settlement penalties.

(The above figures are for illustration only. For a more accurate calculation, scroll down to the examples below)

SETTLEMENT OF THE SELLING PRICE.

Because of this misconception, a lot of Customers think that a Shariah-compliant financing is More Expensive than the Conventional Loan. This is just a half-truth. While the Selling Price Outstanding is RM890,000 as contracted in the Aqad, Islamic Banks are required to provide “Rebates” (Ibra’) on the Selling Price Outstanding to be fairer to the customer. Although entitled to earn the full amount of Selling Price from the Aqad, a Rebate on the Selling Price should always be given.

HISTORY OF GIVING REBATES

Traditionally and by nature, Rebates are discretionary on the financier, to be given to the Customer as the Aqad allow for the collection of the full contracted Selling Price. To achieve parity with the Conventional Loans, Islamic Banks have opted to give rebates on the Selling Price, based on their discretionary calculations. This may include early settlement penalties or other charges, which improves the Bank’s profit ratio. This has resulted in inconsistencies to the amount of rebate given; one Bank may charge differently to another.

MAKING REBATES MANDATORY

BNM issued a Guideline for Rebate (Ibra’) for Sale-based Financing in 2011 to address this inconsistent practice by making it MANDATORY (not discretionary) for Islamic Financial Institutions to provide rebates under specific scenarios. Under the guidelines, a specific formula is given for 2 scenarios where rebate may arise:

Rebate arising from the waiver of Unearned Profit due to Early Settlement of Financing.

REBATES ON THE CEILING RATE

This is applicable where the structure allows for pricing based on floating-rate, usually prevalent for long term structures such as a 30-year home financing. The structure allows for the customer to be charged based on a floating rate ie prevailing market rate which moves in tandem with the various base rate benchmarks. The benchmark can also be a conventional pricing rate that moves with the market. For example, the prevailing rate consists of a Base Rate of 4.05% + Margin of 1.45%, giving us an effective rate of 5.50% pa.

Therefore:

Financing Amount : RM1,000,000

Base Rate : 4.05% (moving rate)

Profit Margin : +1.45% (fixed or movable based on event)

Effective Profit Rate (EPR) : 5.50%.

Tenure : 3 years

Instalment Amount (EPR) : RM30,195.90 per month

However, for the purpose of Aqad, all the terms must be agreed upon execution and perfection of Aqad. If the Rates are moving, how can all the rates be agreed upon up-front? Thus there is a need to agree on one Rate where Islamic Banks can conclude the Aqad with an agreed-upfront Selling Price. To conclude the Aqad by formalising the Selling Price, the following is required.

And for the purpose of day-to-day charge of Instalment and Profits, the following applies:

Financing Amount : RM1,000,000

Base Rate : 4.05% (moving rate)

Profit Margin : +1.45% (fixed or movable based on event)

Effective Profit Rate (EPR) : 5.50%. (moving rate)

Tenure : 3 years (fixed)

Instalment Amount (EPR) : RM30,195.90 per month (changeable based on EPR or events)

This means, the Aqad we have contracted is based on CPR of 10%, but on day-to-day basis, the EPR is 5.50%. Therefore, Rebate on the Ceiling Profit Rate is:

10.00% less 5.50% = 4.50%

In value, the monthly rebate is RM2,071.29 and TOTAL rebate based on Price is RM74,566.27

REBATE ON EARLY SETTLEMENT

The second element of misconception was what mentioned earlier. That to early settle you have to pay ALL the remaining balance of the contracted Selling Price. This proved to be a major contention by customers, although it is NOT TRUE in Malaysia.

Mandatory Rebate must be given in the following early settlement scenario, and a penalty for early settlement cannot be imposed as it will be deemed as trying to earn additional profit on top of whatever profit is rightfully yours. Upon early settlement, the Unearned Income or Profit must be waived from being charged to the customer. A Bank can therefore claim profit that is rightfully theirs ie “earned”.

The scenarios where mandatory Rebate must be given are:

Financing when early settlement has occurred including from prepayments

Financing where there is a restructuring into a new financing contract

Financing settlement in cases of default

Financing settlement where the customer cancels or terminates the financing before maturity date.

Early Settlement Amount is RM485,127.69 on Month 22 i.e Outstanding Selling Price (+RM497,308.90) less Unearned Profit Outstanding on Settlement Date (-RM14,183) plus Earned Profit Not Yet Paid on Early Settlement Date (+RM2,001.79). This amount is at par to what a Conventional Loan figure for Early Settlement would be. In fact, in some circumstances, a Conventional Loan figure may include additional Early Settlement Penalties that generally are not allowed under an Islamic Banking financing.

EARLY SETTLEMENT PENALTIES

In essence, Islamic Financing is govern by the understanding that debt must be settled (debt cannot be forgiven) and efforts to repay debts early should not be taken as opportunity to earn additional returns. If actual cost is incurred from the early settlement of the debt, that cost can be recovered but not additional income. Under the Ibra guidelines, it allows the Banks to charge reasonable estimates of “Actual Costs” incurred if early settlement is made within a “lock-in period” based on the following conditions:

Costs that has not been recovered arising from a discount element in a specific period in the financing. For example, the Bank offers a Home Financing rate of 1.88% p.a. for the first 2 years and BR+1% thereafter. The reasonable costs in this case is the differential between BR+1% less 1.88% ie the shortfall from the promotional period against normal board rates.

Cost borne by the Bank during initial stages of the financing for example Legal Fees absorbed by the Bank. If the package offers a Zero-moving cost solution, it means the Bank pays the legal and stamping fees for the customer to move from the other Bank. The cost will be recovered by the Bank.

Consequently, any reasonable costs incurred by the Bank as a direct result of the Early Settlement can be considered to be recovered by the Bank. The Shariah Committee of the Bank can take into consideration to approve the request to charge such fees, based on acceptable justification. This includes any “break funding costs” incurred by the Bank.

CONCLUSION

The common perception is that for Islamic Banking products in Malaysia, the Selling Price (which includes future profits ie Unearned Income) must be paid to early-settle an Islamic Financing is inaccurate. Currently, there are provisions to waive the unearned profits from the final settlement amount as guided by BNM. In essence, the settlement amount should consist of only the Outstanding Principal Amount + any due amount or earned amount still outstanding on the settlement date. This means, the settlement amount for Islamic Financing is NOT more expensive than a conventional loan, and in some cases, is even cheaper than the conventional settlement amount.

I had this conversation recently until the wee hours of morning, and although I never thought a lot about it, I have come to the conclusion that there cannot be an exact replica of the Risk Management in the conventional sense.

Risk Management is a tool used by all conventional banking institution in the name of good governance, risk mitigation and prudent practice. It looks at financial exposures and its inherent risks to the business, and deeply believe in the risk-rewards pay-off within the generally accepted risk appetite of the organisation. It focuses a lot on control processes, performance monitoring, collateral value, and decision making policies for credit, market and systemic risks.

To a large extend, the risk management framework employed by the conventional banking businesses can be easily adapted by Islamic Banking counterparts. The components are the same, and there is little argument on its applicability under Shariah law. However, the risk management framework for Islamic Banking institutions must be inherently different as well, or maybe extended to include a bigger scope. It cannot just be seen as a replica of the conventional business; the foundation of Islamic Banking is definitely different.

There are a few divergence in the reason an Islamic Banking institutions should (ideally) follow. This is an on-going argument on the fact while Islamic Banking claims to be a different business model, but it is still engineered by the rules of a conventional organisation. But what are these divergent reasons for setting up an Islamic Banking business?

The lending of money to make money is forbidden.

This may seem like a trivial thing for Islamic Banking as many will say there is no difference between profit and interest. But for us practitioners, there is a big difference in its concept. Because of this difference, the way we think about how a product can be structured is paramount. Underlying contracts, assets, ownerships and roles and responsibilities becomes different from a tranditional / conventional bank (whom are essentially a money lender). To validate a transaction, all tenets and requirements in an Islamic contracts must be met or else it becomes an invalid transaction and any gains from it must be given to charity. Any gains obtained without fulfilling the transactional can be deemed as usury (riba’).

Some terms are pretty alien to traditional banks, such as commodity purchase, operating lease and rentals, sequencing and ownerships. This is where the divergent begins, because Islamic Banks espouses the concept of “trading” and “entrepreneurship” and “partnership” and “service provider”, away from the “lender-borrower” arrangement. Traditional banks struggle to understand issues of ownership of assets, risk and loss sharing, purchases of commodity and rental of assets. These activities are beyond traditional banking, and may become an operational risk issue if it is not fully embraced.

Islamic Banking should be more closer to a venture-capitalist, crowd-funding model than traditional banking.

The fundamental requirements for earning a profit (and to a bigger extent, how much we can earn from a transaction) is the element of risk sharing, which mean both customer and financier takes some form of the risks of the venture. At the same time, such “risky” venture is mitigated by way of ensuring it is not overstretched i.e. the transactions must be either asset-backed (including the presence of collaterals) or asset-based (evidenced by real trading or assets or commodities) to reflect economic activity.

The amount of risk taken under an Islamic contract can be higher (for contracts such as Mudharabah or Musyaraka financing) but it must be reflective of the economic reality and available assets.

The risk assessment of an Islamic contract must then be enhanced to behave similarly to what a venture capitalist can accept. There will be direct risks on equity, investments and returns. There will be corresponding returns as well. But such concepts will be difficult to digest if the bank is set up based on traditional banking fundamentals, which caters for a totally different profile of stakeholders.

As far as possible, the Shariah committee draws a line for transparency, fairness, and justice.

Islamic Banking should be an extended but integral part of economics. Islamic Banking is supposed to be more than a bank. It shoulders a broader responsibility to the people by looking at needs and providing products that serve a purpose. The idea of responsible financing, transparency and customer service should be the by-word of an Islamic Bank. The payment of Zakat (tithe) on profits which goes back into the community recognises the financial role that it needs to play. Corporate Social Responsibilities also play a role.

In this repect, the Shariah committee plays an important role as gatekeepers to the products and services on offer. Because of the unfamiliar territory of Islamic products, Shariah insists that transparency is critical to avoid uncertainty (gharar), the terms to the products are fair and the banks are ethical in its conduct to ensure justice. Fees and charges must reflect actual costs. Efforts are made to help a customer in distress. And conduct of the bank must comply with the requirements of Shariah.

SO, BASED ON THE ABOVE, WHAT ARE THE OF RISKS FACED BY ISLAMIC BANKS?

As a general rule, all risks faced by a conventional Bank must be “transferable” i.e the nature of the financial transaction must, as far as possible, allow for the TRANSFER OF RISKS. Wherever the opportunity arises, the Bank must be able to quickly pass the risk of the asset or valuation to the customer. Such understanding is also apparent in Islamic Banks. Looking at most Islamic Banking contracts, their structure allows for the transfer of risks, which follows the transfers of ownership, responsibilities and obligations from one party to the other. Contracts such as Murabahah, Musawamah and Qard works by transferring the ownership, responsibilities and obligation from the Bank to the Customer.

Alternatively, mostly exclusive to Islamic Banks, are structures that allows for SHARING OF RISKS. The structure is more “participative” in nature, where there are benchmark by which determines the level of risks a party should have. The regular types of contracts that continues to share risks are Mudarabah, Musyarakah and Ijarah.

COMMON RISKS

As mentioned before, the risks faced by a conventional bank and Islamic Bank should be very much the same, except for risks arising to the execution of Islamic contracts or pronouncement of the Shariah. While there will be common elements of risks for both types of Banks, the importance of Shariah ruling and decisions result in Islamic Banking becoming so unique. The following are the Risks commonly faced by Islamic Banks:

GENERAL RISKS – Risks existing in both conventional and Islamic banks.

Credit Risks – Arises due to counterparty risks (possibility of default by the party taking financing) where the counterparty fails to meet its obligations, in terms of payment, uncertainty of industry, change of direction or diminished collateral value. This lead to settlement risks which means the Asset quality has diminished.

Market Risks / Interest Rate Risks – More macro in terms of effect on the risks. It relies on the performance of the market as well as the quality of the financial instruments (price, performance, valuation, demand, yields and inability to reprice. It leads to exposure to interest rate risks, where the risk of the bank increases with movements in the rates.

Liquidity Risks – Refers to the risk of inability to return cash to investors or stakeholder in stressed scenarios, resulting in forced borrowings from the market (usually at higher price) coupled with the possibility of not able to dispose assets. This may lead to valuation risks.

Operational Risks – Due to inadequate control of internal processes and operational practices, the risks may result in real loss of income and potentially reputation. Human errors may be difficult to unwind especially if there is financial implications. There may also be legal risks as it may be considered a breach in contract by the bank.

Transactional risks– Especially under Islamic Banking structures, transactions play an important role as part of the Aqad, where required. For example, the sequencing of a Murabahah transaction. Failure to ensure compliance to the Aqad requirements will lead to potential invalid transaction and loss of income (or flow to charity).

Valuation Risks – Due to the nature of some Islamic Banking contracts, especially equity based structures, there will be challenges in valuation of the portfolio. Reduction in valuation will result in real losses for the investors.

Displaced Commercial Risks – Displaced Commercial Risk (DCR) refer to the risk of mismatch between the fixed/contracted obligation to the depositors vs the uncertain returns on the financing (income) which may result in the income is insufficient to meet the obligations to the depositors. For example, the commitment for Islamic Fixed Deposit is 4% (contractual) but the Financing portfolio into which the Fixed Deposits is deployed into only earns 3% (actual returns). Therefore, the 1% shortage is the DCR where the Bank will have to flow 1% of income from other portfolio to meet the deposit obligation of 4%.

Shariah Compliance Risks – The operation of an Islamic Bank is hugely dependent on the requirements of the Shariah Committee and approvals obtain on the process and procedure. Inability to comply with Shariah requirements puts the operations of the Islamic bank at risk as the department may be regarded as non-Shariah compliant business.

Fiduciary / Ownership Risks– Some of the structures under Islamic contract requires the bank to operate outside the scope of a financial intermediary. It requires the bank to hold property or trade commodities or own and lease assets, with various contracts using various roles and responsibilities. The risk of multiple roles and function must be clearly defined and implemented.

As mentioned, Islamic management of risks should not be any different for the base of conventional bank’s methodology of measuring risks. There must be deep understanding of the products and structure for the bank to be able to assess the risks associated. To manage an Islamic Bank and its risks, the bank must first identify each of the risks and form safeguards to settle the above. Then only an Islamic bank can formulate suitable controls to ensure the Shariah specific processes and Shariah pronouncements are being monitored and implemented with sufficient support (internal or external). Wallahualam.